Photo: Anatoliy Babiychuk, http://www.dreamstime.com/business-objects-stock-images-rimagefree198174-resi6330728
Working with a new client and looking through their payroll files we realized that they had filed taxes as a Sole Proprietorship and not as their elected status of an S-Corporation. Fortunately we were able to amend 3 years of tax returns and the client got tax refunds of approximately $21,000 which they had overpaid in taxes for those 3 years. Yes, the business entity type you choose for your business can certainly have an effect on your taxes!
The 4 Business Entity Types and their advantages and disadvantages:
Sole Proprietorship: When going into business for yourself, this is an easy way to start out. This is a one-owner entity and no legal filing is required (although a state business license may be required). The owner will not have to worry about paying him or herself a salary, so there are no payroll tax filings required which makes it easy. The income and expenses from the business is reported on the owner’s 1040 usually as a “schedule C business”. The disadvantage of a Sole Proprietorship is that net income from the business will be subject to self-employment tax in addition to regular tax, which was the case with our new client. New businesses often experience losses the first years in business, so self-employment tax may not be a big issue for a start-up business. When the business is growing and becoming more profitable, the owner would most likely benefit by forming a Corporation and possibly electing S-Corporation status.
Partnership: An entity with more than one owner. Like the Sole Proprietorship no legal filings are required for a General Partnership (but it is advised to make the partnership either limited or an LLC for liability protection), and the partners are not allowed to pay salaries to themselves. Income and expenses are reported on the partners’ 1040s on a K-1 schedule, and net income is subject to self-employment tax for the partners. Filing of an annual Partnership tax return is required.
Corporation: This is a good choice of entity for a company that is looking to go public, since there is no limit to the number of shareholders. The disadvantage is double taxation. The Corporation pays taxes on net income on the corporate tax return. The shareholders are paid dividend distributions by the Corporation which are again taxed on their individual 1040s.
An S-Corporation is a special tax treatment for qualifying entities. It can have anywhere from 1 to 100 shareholders. A legal filing is required. For profitable businesses, this may be a good choice of entity type for business owners since net income is not subject to self-employment tax. The S-Corporation’s net income is taxed on the shareholders’ 1040 via form K-1. Distributions are tax-free to the extent of stock basis, but the owners must pay themselves a “reasonable salary”, therefore, file payroll tax returns. In other words, the owners cannot choose not to pay themselves salaries and just take tax-free distributions, even if it seems tempting to avoid the payroll taxes… The owners’ personal assets are protected from creditors of the corporation. An annual S-Corporation tax return is required.
Limited Liability Company (LLC): An entity that is easy to organize. No legal filing is required, but is advised. LLCs can be taxed as a Sole Proprietorship if there’s only one member, as a Partnership if there are at least two members, or as a Corporation if they so elect. LLCs are very flexible as they can have more than 100 members. They can be owned by foreigners and by businesses and can have more than one class of stock.
This is just a brief description of the four business entity types. We recommend you seek advice from a CPA when selecting the business entity type that is right for your business.
Director of Marketing and Accountant
Allen & Company, PC, Kennesaw, Georgia